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What Is a Derivative?

A more complex type of investment, derivatives offer countless opportunities for making money -- if you're willing to take the risk.

There's a whole world of investing that goes far beyond the realm of simple stocks and bonds. Derivatives are another, albeit more complicated, way to invest. A derivative is a contract between two parties whose value is based upon, or derived from, a specified underlying asset or stream of cash flows. Options, swaps, and futures are commonly traded derivatives whose values are impacted by the performance of underlying assets. An oil futures contract, for instance, is a derivative because its value is based on the market value of oil, the underlying commodity. While some derivatives are traded on major exchanges and are subject to regulation by the Securities and Exchange Commission (SEC), others are traded over-the-counter, or privately, as opposed to on a public exchange.

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Uses of derivatives

With a derivative investment, the investor does not own the underlying asset, but rather is betting on whether its value will go up or down. Derivatives usually serve one of three purposes for investors: hedging, leveraging, or speculating.

Hedging is a strategy that involves using certain investments to offset the risk of other investments. If you own a certain stock and are worried about its price falling, you might buy a put option, a type of derivative, that gives you the ability to sell that stock at a certain price at a specific time. This way, if the price falls, you're somewhat protected because you have the option to sell it.

Leveraging is a strategy for amplifying gains by taking on debt to acquire more assets. If you own options whose underlying assets increase in value, your gains could outweigh the costs of borrowing to make the investment.

Speculating is a strategy that involves betting on the future price of an underlying asset. You can use options, which give you the right to buy or sell assets at predetermined prices, to make money when such assets go up or down in value.

Options

Options are contracts that give the holder the right (though not the obligation) to buy or sell an underlying asset at a preset price on or prior to a specified date. A put option gives the holder the right to sell an asset at a predetermined price and is comparable to having a short position on a stock. If you buy a put option, you'll want the price of the underlying asset to fall before the option expires. A call option, meanwhile, gives the holder the right to buy an asset at a preset price. A call option is comparable to having a long position on a stock, and if you hold a call option, you'll hope that the price of the underlying asset increases before the option expires.

Swaps

Swaps are contracts in which two parties agree to exchange cash flows. Swaps can be based on interest rates, foreign currency exchange rates, and commodities prices. Typically, at the time a swap contract is initiated, at least one set of cash flows is based on a variable, such as interest rate or foreign exchange rate fluctuations.

Futures

Futures contracts are agreements between two parties where they agree to buy or sell certain assets at a predetermined time in the future. While futures contracts were initially associated with commodities, today, they run the gamut from stock market indexes to Treasury bonds to foreign currencies.

While derivatives offer countless opportunities for making money, their complex nature often makes them unsuitable for new investors. If you're just beginning to dabble in investing, you may want to stick to stocks, bonds, and other such investments that are far more straightforward.

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